ETF Mutual Funds: The Best of Both Worlds

This relatively new way to invest is tax efficient, transparent, and generally costs less.

For decades, financial advisers and their legions of retail clients have generally preferred mutual funds as the investment option of choice for professional management of their assets. In recent years, much has been made about the migration of a notable amount of assets from the investing public from mutual funds into individual ETFs.

Why has this occurred? Cost is one of the top factors, as ETF issuers such as iShares, Vanguard, and State Street have hammered home their message that ETFs generally charge a fraction of the management fee that most mutual funds do. Secondly, tax efficiency in ETFs continues to trump that of mutual funds, and years like 2008, where the market declined substantially, left many mutual fund holders subjected to sizable capital gains taxes in a principal losing environment. This covert penalty simply makes the case to transition to ETFs even stronger to those who are considering selling their mutual funds and looking elsewhere. Transparency of the holdings is yet another factor, and often mutual fund holders complain when their "Large Cap Value" managers are caught owning some Microcap stocks at the end of a reporting period because they were desperately chasing their benchmarks and felt compelled to take risk outside of their designated style boxes to achieve such returns. With ETFs, investors don't run the risk of "not knowing what they're investing in" because the individual underlying holdings on the ETFs are published daily by the fund sponsors.

In the past few years, managers who are adept at managing portfolios of ETFs have begun running their strategies within the wrapper of a traditional mutual fund. Since many financial advisers are comfortable with selling mutual funds to their clients and don't want to give up on their quest for benchmark-beating performance through active management, ETF mutual funds are a perfect match.

One misconception that some may have on the surface when hearing the title "ETF mutual fund" would be that the funds are simply another variety of an index fund, which is designed to just track a standard market benchmark. In other words, average performance each and every year in line with a benchmark like the S&P 500 or the Russell 2000, which is relegated to under-performance each and every year net of product fees and investment advisory fees charged by the adviser to the client. Nothing could be further from the truth, as these managers of ETF mutual funds are generally running risk-controlled capital appreciation, income generating portfolios, or even absolute return strategies, and tactically using the broad array of ETFs that are available in a way to outperform the market while generally mitigating risk. Some ETF mutual funds even use ETF options within their strategies, whether it be covered call selling or put buying in order to generate additional income or hedge and collar positions.

In recent years, the emergence of ETFs that track commodities, fixed income, volatility indexes, actively managed and quantitative strategies, as well as short and leveraged products has made it possible for managers of ETF mutual funds to express a variety of views on the market and invest in a multitude of asset classes. A manager can be long/short, have exposure to areas of the market such as Emerging or Frontier markets, currencies, metals or livestock, or dozens of other possibilities that simply weren't available a decade ago when the majority of ETFs on the market were vanilla, broad-based index ETFs like Dow Jones Industrials (DIA) and S&P 500 (SPY).

Mutual funds of ETFs make sense for financial advisers and investors who either lack the know-how to sort through the ever-growing universe of 900+ ETFs or are unable or unwilling to formulate and run a portfolio of ETFs; professionally managed ETF mutual funds combine the best of two worlds.

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